HM Revenue & Customs (HMRC) do a toolkit for advisers. This is our own version - with planning points.

HMRC instructs its staff to examine directors' private expenditure during the course of an enquiry into a close company's books and records. In most cases the company will be expected to produce a transaction history of any director's loan or current account.

Overview

  • A director may receive a loan advance from his own company provided that it is not in financial difficulty and subject to adherence to the provisions of the company's articles and the 2006 Companies Act.
  • Shareholder approval (generally by ordinary resolution) is required for loans in excess of £10,000 (the limit is £50,000 if the loan is to meet expenditure on company business).
  • The board should always agree loan terms and document them accordingly.

An overdrawn director’s current account is the same as a loan account

An overdrawn director’s current account that is not repaid is treated as an outstanding loan and this can create tax complications for both the company and its director:

  • Company tax: a section 455 tax charge
  • Income tax: a taxable benefit on interest-free loans or tax charge on write off
  • Compliance: Corporation tax return extra schedules and P11D reporting

Company tax charge on outstanding loans to participators: s 455 CTA 2010

  • When a director (or any other participator in a close company) is made a loan which is left outstanding for more than 9 months after the company’s accounting period end, the company will be required to pay tax under s.455 CTA 2010.
    • S 455 tax is payable at 25% of the outstanding loan balance.
    • Tax is due 9 months and one day after the end of the accounting period in which the liability arises.
    • When the loan is repaid in full or in part s 455 tax is fully or proportionally repayable 9 months and one day after the end of the accounting period in which the repayment is made.
  • Where a loan is repaid and then a similar sum advanced shortly after, under measures which apply from 20 March 2013 the repayment may be matched to the later advance, the effect being that there is no actual repayment (see New tax avoidance measures). 
  • Where a director maintains a current account and also a loan account, the two balances may be kept separate and accounted for separately.
  • Two directors (typically spouses) may agree between them to allow an offset so that one's loan credit is set against the other's loan debit: HMRC will not accept the offset unless there is evidence to prove the intention to create a joint loan account.
  • If one individual has two loan accounts that are accounted for separately for reporting purposes and one is overdrawn HMRC may try to resist aggregating them for tax and so will not treat the two as one net balance.

Top tip: it is vital that the company and relevant director agree the treatment of aggregating or offsetting loan accounts at the time that the loans are made or when two are to be offset and record this in a board minute at the time. Better still for the board to pass a resolution to agree treatment. Back-dating of any of this documentation is bad practice, unless there is a genuine reason why it was not possible to record the details of a meeting at the time.

New tax avoidance measures

In March 2013 HMRC announced three new measures which extend the s 455 tax charge to deter tax avoidance using close company loans. These measures are intended counter the following arrangements where a close company:

  • makes a loan advance to a LLP or a trust in which a participator is a member or associated
  • is party to an arrangement which confers a direct or indirect benefit to a director, or
  • where "bed and breakfasting" is used: where a loan is repaid shortly before the 9 month period elapses and a new loan advance is made shortly after.

These affect new loans and repayments on or after 20 March 2013 and are covered in detail in our Close Company Loan Toolkit. The danger is that the proposed measures may affect some accidental situations where there is no tax avoidance motive.

Taxable benefit: if the loan is interest-free and exceeds £10,000 (£5,000 up to 5-4-2014)

  • If the overdrawn (debit balance) on a director's current account with the company exceeds £10,000 it is treated as an employment-related loan.
  • A taxable benefit will arise on an employment-related loan when the employee does not pay interest to the employer at HMRC's official rate of interest.
  • The cash benefit of the interest free loan for tax purposes is calculated by using an averaging method or on a daily basis. There may be a difference between the two methods and HMRC will use the daily basis where a loan balance fluctuates throughout the year.
  • The cash benefit is the difference between interest calculated at HMRC’s official rate and the interest paid (if any has been charged).
    • The taxable benefit of interest calculated is required to be reported on form P11D.
    • A P11D dispensation does not apply as this cannot cover beneficial loan interest.
    • Class 1A NICs will be payable by the company on beneficial loan interest, which will also be required to complete form P11DX.
    • The director will be taxed on the benefit received.
  • If a company does not write up its transactions contemporaneously it may be difficult for it to accurately determine when this type of benefit arises.

Top tip: if a director is charged and pays interest at HMRC's official rate on loans with a balance in excess of £10,000 this reduces the reporting requirements. It is sensible to work out whether it is cheaper for the director to pay tax on the beneficial loan and the employer to pay the Class 1A NICs on the benefit or for the director to pay interest on the loan. Where the director is a higher rate taxpayer there may not be difference. In term of reporting, if interest is charged, it is still necessary to report the loan on form P11D however there is no Class 1A for the employer. If the director does not pay the interest you must prepare a P11D and he will need to report the benefit under Self Assessment and this will probably be adjusted for via a PAYE coding which will need checking.

Write off or release of an overdrawn director’s loan

Summary

When a close company writes off or releases a loan made to a director:

a) who is a participator, the amount released is treated as a distribution, or

b) who is not a participator, the amount is taxable as employment income.

In most small companies the director will be a shareholder and will be entitled to vote at board level and so will be a participtor. The distribution treatment will apply to any loans made and written off to the director or his family.

  • As a distribution (effectively as a dividend) for Income Tax purposes but NOT also as earnings for tax purposes.
  • As earnings for NICs purposes (enter on P11 deductions sheet - calculate on your payroll).
  • The write off is an unallowable expense for Corporation Tax purposes.
  • Class 1 NIC is tax deductible for the company.
  • Under s 458 CTA 2010, any s 455 CTA 2010 tax is repaid to the company following the release or write off of the loan.

If the company has distributable reserves it will be preferable to declare a dividend and treat the loan as a contra paying the dividend in order to avoid a NICs charge.

Conversely, the company can also vote a bonus and treat the write off as earnings. If it does this it will need to ensure that it is mindful of reporting requirements under Real Time Information (RTI) reporting for PAYE.

Income Tax

  • A loan that is released or written off will in general be treated as the taxable income of the director (see below for tax on death).
  • If the write off is made in favour of a director who is a participator in a close company, and the company is or was chargeable to a s 455 CTA 2010 charge, the amount written off is taxed as if it is a distribution under s 415 ITTOIA 2005. This means that the amount of the write off is treated as net income received after deduction of notional tax on the participator's tax return, but the tax credit is not repayable: it is a dividend.
  • If the company is not close, or the loan is made to a director who is not a participator (or to any other employee) a loan write off is treated as earnings under s 62 or s 188 ITEPA 2003.
  • When s 62 applies the loan is treated as net pay and so it needs to be grossed up for PAYE purposes and PAYE and NICs applied as if it were a cash payment, this would be used if say, the employee was entitled to a bonus and it was agreed that the bonus would be used to offset an outstanding loan. 
  • The other method is dealing with loan write offs under the benefits code. The benefit (the amount written off) is reported on form P11D (section M) and Class 1 NICs is calculated on the value of the benefit via the payroll.
  • The s 415 ITTOIA 2005 tax treatment takes priority over a s 188 ITEPA 2003 employment income tax charge so there is no question of double taxation.
  • If a loan write off occurs on the death of the director there is no tax charge s190 ITEPA 2003.

National Insurance Contributions (NICs)

  • A director's loan released or written off is treated as earnings for NICs purposes if it constitutes remuneration or profit derived from an employment.
  • Whether the release is earnings is a question of fact.
  • A loan written off on death, is not treated as earnings for NICs, neither is a loan write off where it was made to a participator who is neither a director or employee
  • There may be other situations where a write off it not treated as being employment related. For example in cases of fraud (expect HMRC to enquire into any claims of this nature).
  • The amount on which to calculate NICs is on the amount written off.
  • A write off should be agreed by shareholders, rather than the directors, and if a company's solvency is in question, directors should take legal advice before writing off their loans.
  • When a loan is charged to tax under s 415 ITTOIA 2005 (the release of a loan to participator in close company) the employer will treat the write off as a distribution however it must then account for Class 1 NICs via its payroll.
  • If a director is not a participator, normally employee tax treatment applies: it is treated as employment earnings under s 62 or s 188 ITEPA 2003 the company includes the loan write off as if it were gross pay for NICs.
  • For a detailed discussion see What are earnings for NICs purposes?

Loan write off: on termination of employment or office

Corporation Tax

  • S 321A CTA 2009 (introduced in FA 2010) denies a close company Corporation Tax relief when it writes off a loan to a director.
  • For accounting periods prior to 24 March 2010 it was in theory at least, possible to write off such a loan, however HMRC will challenge a write off if it considers that this amount is not wholly or exclusively incurred for the purposes of the business (s 34 ITTOIA 2005)


Credits to a director's loan account

Bookkeeping can be a major headache for many running small business and a director's loan account will often be left for an accountant to review at a period-end. Unfortunately under Real Time Information Reporting (RTI) this could be a dangerous practice.

  • Under RTI salary and wages are required to be reported to HMRC before payment is made. A situation which may arise where net pay is credited to a loan acccount following the voting of salary or a bonus prior to the year end. The credit will be treated as a payment and so an RTI report is required to be run before the accounting entry is made.
  • A further issue is to ensure that there are no timing differences between the date a dividend or salary is voted and the date credited to the loan account, to avoid a beneficial interest change, see implications in Taxable benefit: if the loan is interest-free and exceeds £5,000, above.

Planning points: rather than review a loan account at the year end and then vote salary or dividends to repay it, it may be sensible to vote both at the start of the year. This way a director has funds available to draw on without the added complication of having to review for RTI reporting.
The company may also register to run an Annual Scheme for RTI and this will also reduce reporting requirements.

Also check that:


Debits to directors' loan accounts

Where a company pays a personal bill on behalf of the director (or his family) the amount should be either:

  • Debited to the director's loan account, or
  • Treated as if it is a payment on account of earnings and the amount is then grossed up via the payroll, with PAYE and NICs applied, or
  • Reported on form P11D

Where a loan account is overdrawn, new debits will increase the outstanding balance and there may be a taxable benefit in respect of loan interest.

Back to basics

{slide= FAQs: How does a director get to create a loan?}

Typically a director will have what is known as a "current account" with the company. This should be in credit - and it will have been created by bookkeeping when the company owes the director for something such as expenses that the director has incurred on the company's business, and has not been reimbursed.

For example: a director purchases a desk on behalf of the company for £1,000. Bookkeeping entries are:

DR Fixed Assets - £1,000
Cr Directors Loan - £1,000

A director may borrow funds from the company by an agreed loan, as approved by shareholders or, a director may borrow funds on account - ahead of an anticipated dividend or as a salary. Sometimes by error or design illegal borrowing (illegal because it is not shareholder approved) takes place. In any event borrowing creates a loan, and if the loan is not repaid there will be tax consequences. If the loan is made as an advance of salary, there are also implications for reporting under RTI.

{/slide}

Further reading in this series, see:
 
 
 
 
 
 
 
 
 
 
 

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